Four Reasons to Own Individual US Stocks Instead of an ETF
The popularity of Exchange Traded Funds (ETFs) is easy to understand. They are inexpensive and easy to buy and sell. A retail investor can buy an ETF that mirrors the S&P 500, for example, for about 9 basis points (0.09%). Certainly, that’s less than any active manager would charge. Couple that with the fact that most active managers do not do better than the passive ETF in most years, and the case is compelling. However, for the high net worth (HNW) retail investor in Canada, there are at least four good reasons why individual stocks are a better choice.
- Income Taxes. For the HNW investor, managing the tax impact on investment earnings is very important. Canada is a very high tax country with a maximum income tax rate of over 53% on interest income and non-Canadian source dividends, and a maximum tax rate after the dividend tax credit of 39% on eligible Canadian dividends. Investors who focus only on management fees, typically less than 1.5% for HNW families, are missing the forest for the trees. The tax savings arising from alert and experienced management can easily surpass the fee differential between active and passive asset allocation. Here are a few things you can do with individual stocks that you cannot do with an ETF:
- Sell an individual security at a loss and carry back the loss to offset gains in previous tax years.
- Sell an individual security at a loss at year end to balance realized capital gains in that year.
- Allocate individual securities among taxable and registered accounts so as to reap most capital gains in taxable accounts and most dividends and interest in registered accounts, thus reducing overall taxes.
- Sell an individual security at a gain in a year in which other income is lower than normal, or in which capital losses have taken place outside of the portfolio.
- Concentration Risk. The idea of buying an index-linked ETF seems to offer the advantage of diversification. After all, it mirrors the performance of the 500 largest companies! However, this is to a great extent an illusion. Because the index and the ETF are based on market capitalization, that is, the value of the various company’s traded shares, companies with very large values, the so-called “Mega Caps”, tend to swamp the index. On September 30, 2021, technology companies comprised 37.5% of the value of the S&P 500. Investors who believed they were making a diversified investment instead found that they were largely buying the shares of about eight technology companies with extraordinarily high values. Even today, after the value of five of those eight stocks plunged, the combined weight of Apple, Microsoft, Amazon, Alphabet, Tesla and Invidia in the S&P 500 is 21%. Compare this, for example, to the combined value of Citibank, Bank of America, American Express and Goldman Sachs, at 3.1%. Most active managers would not invest 37% of a client’s portfolio in one sector, such as technology, and would not allow individual positions to grow so large as did Apple, Amazon, Microsoft and Tesla in the S&P Index.
- The Good, the Bad and the Ugly. When you buy the Index, you become an owner by proxy of every company in it. This may include companies and sectors you would rather avoid for ethical, political or personal reasons. For example, Exxon Mobile, the large oil company, is the 10th highest weighted stock in the S&P 500 today and Chevron is 18th. Tobacco giant Philip Morris is number 43 and Altria, another tobacco company, is number 93.
- Winners are Diluted. One of the great joys of portfolio management is picking a little known or under-followed stock and watching it grow over the years, accompanied by a rising stock price. In a portfolio of individual stocks, one or two great picks can have an outsized effect on returns. Since most such stocks have low market capitalizations at the start, their success has virtually no impact on a large index such as the S&P 500, sometimes for years. Few companies become an Apple or an Amazon, but many can double and redouble in size while still having a relatively small market capitalization compared to the S&P giants. Studies have shown that, over medium to long periods of time, most portfolio returns come from a few significant winners. Active managers have shown that they are good at finding such stocks. Through our history, Baskin Wealth’s clients have generally outperformed the relevant index through careful stock research.
As an example, a strong performer for our clients over the last 7 years has been Live Nation. In 2016, through our research, we recognized that Live Nation shares were undervalued based on its strong market position in the entertainment industry. Live Nation stock is up over 200% since we started purchasing shares, far outpacing the S&P 500. Since our average client owns around 30 stocks, a strong performer has an outsized influence, in this case adding as much as 9% to the portfolio return to Baskin clients. By comparison, passive investors in an S&P 500 ETF would not have benefitted from Live Nation’s rally at all since Live Nation shares were only added to S&P 500 in December 2019 and today account for a paltry 0.03% weighting in the S&P 500 index. Of course, not all picks will perform this well, but it does illustrate how active stock picking can result in outsized contributions relative to passive holdings.
Over the decades, one of the things that we have learned is that there is no free lunch in the investment business. Every decision is a trade-off. Our business is to make the decisions that produce the best results for our clients over time. In this case, we think trading off lower management expenses for the advantages listed above makes a lot of sense.
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